Tutorial 3 - Macro fundamentals

Executive summary

After completing this tutorial, an investor will understand what is meant by macro-fundamentals. In other words, an investor will learn how to analyse an economy and see the "bigger picture". Furthermore, an investor will understand what factors affect the reserves and what affects the exchange rate. It is also important to know what tools are used to manage the economy and interest rates; what the budget is all about, as well as the importance of the investment cycle.

Introduction

Fundamental analysis concerns itself essentially with the question of future profitability. The basic question asked by the fundamental analyst is "how good will this company be as a generator of profits in the future?" The basic assumption underlying fundamental analysis is that ultimately, the profitability of a company will determine the path that its share price takes.

Fundamental analysts take two types of factors into account when establishing the 'intrinsic value' of a particular share:

Macro-fundamentals - These are factors that affect the market as a whole, such as economic, political and monetary factors.

Micro-fundamentals - These are factors affecting an individual share or group of shares. Various parameters or ratios are used in order to carry out such analysis.

Macro fundamentals

Macro fundamental analysis begins by determining the state of the economic environment and the implications of that environment for investment decisions. Growth is the focal point when analysing equity investments, since growth in earnings and cash flow is expected to provide the basis for growth in dividends and share prices.

The dividend yields on ordinary shares are often substantially lower than the current yield that can be found through long-term commitments, such as bonds. Accordingly, a share can only be a desirable investment if one expects the growth in the share price to more than cover the gap in current bond yields and share dividend yields. It is important, therefore, that the analyst form some judgement as to future long-term secular growth of the economy and its major components, and also an opinion concerning the cyclical outlook for the economy.

Economic and demographic analysis provides a background for industry and company analysis. Economic analysis also provides a background for estimating levels of interest rates and the long-term trend of price-earnings ratios. The analyst also would hope to spot sectors in the economy that appear to offer better-than-average profit opportunities and relate that information to specific companies.

For example, in the 1950s demographic data suggested a change in the growth and age composition of the United States population. The percentage of the population represented by the young and that represented by the old were expected to rise significantly, while the middle-age group remained static or declined a bit.

Based on this data, the purchase of Levi-Strauss was recommended (which manufactured clothing favoured by the young) and the sale of Botony (which manufactured suits for the middle-aged businessman). Following those recommendations proved to be quite profitable. The purchase of healthcare industry shares were also favoured, because of the expected growth in the older-age group that was being increasingly supported financially by the federal government.

The future is unlikely to be a mirror of the past, but reviewing the past offers an understanding of the interaction among important variables and forms a base for making projections.

Analysis of the economy

There are various advantages or benefits attached to investing in shares:

Investment performance is associated intimately with the economic activity of the nation. Companies typically perform well when the economy is strong and prosperous. Not all industries and companies prosper equally, and the investor eventually must assess the impact of a changing economic environment on particular companies.

Underlying determinants of the level of economic activity

Gross Domestic Product (GDP) - The broadest measure of economic activity is the gross domestic product or GDP, which represents the value of the total amount of goods and services produced in a national economy (e.g. agricultural output, factory production, construction and trade, etc.). The GDP can be viewed as a total sales index, since the marketplace is the gauge for measuring value.

The two ways of measuring GDP is either at "market prices" or at "factor cost".

In the case of market prices, one is looking at it from the point of view of people buying the output of the economy.

In the case of factor cost, one is looking at what people earn by producing the goods and services in the economy. These are so called factor earnings, i.e. production: labour, capital and land.

The GDP includes exports but excludes imports. GDP measures the total South African production and although, imports are consumed locally, they are produced overseas and are therefore not part of the GDP. Exports, however, are part of the GDP because they are produced locally.

The GDP can be used to show how much an economy has grown or contracted during a given period. Again, GDP can be measured by eliminating the effect of inflation.

By applying the GDP deflator and making allowance for inflation, we arrive at GDP at constant prices (i.e. all figures are given in equivalent money terms).

If no allowance is made for inflation, it is called GDP at current prices.

The real growth rate of South Africa (i.e. with inflation eliminated) has been dismal in past years. In fact South Africa has experienced low growth since the 80's. During the 80's and 90's real growth in GDP averaged only 1.4% - 1.5% annually compared with 3.1% in the 70's and 5.8% in the 60's.

YEAR

REAL GROWTH IN GDP

1960

5.8%

1970

3.1%

1980

1.5%

1990

1.4%

The classic definition of a recession is two successive quarters of negative growth.

Gross National Product (GNP) - This is a wider concept than GDP in that it takes into account the earnings of South African companies overseas and from this deducts the payments sent overseas by foreign owned businesses in South Africa. These payments take the form, for example, of dividends and interest. The result is an item called "net factor payments to the rest of the world". In South Africa's case, this is generally negative and therefore means the GNP is smaller than the GDP.

Gross Domestic Expenditure (GDE) - This is defined as the value of total spending on final goods and services in the economy, including investments in stocks and fixed assets. It consists of three components:

Private consumption expenditure;

Government consumption expenditure; and

Investment.

Investment covers investment spending by government and the private sector. Consumption, on the other hand, relates to the expenditure on current requirements (e.g. in a household's case, consumption expenditure relates to buying food, clothing, etc. while investment refers to bond repayments, investment in life insurance, etc.)

Since GDE measures total expenditure in the economy, it includes imports but excludes exports (being expenditure by the rest of the world on South African goods and services). Private consumption expenditure is generally divided into spending on:

Durable goods - household appliances, TV sets, motor vehicles, etc.

Semi-durable goods - clothing, etc.

Non-durable goods - food, etc.

Services - rent, medical fees, etc.

These different categories of spending behave differently during the course of the economic cycle. Spending on durable goods, for example, is the first to feel the effects of a downturn, while spending on non-durable products (such as food, etc.), and other necessities tend to continue as before.

Investment is an important item to watch as a lack of investment may lead to future problems because not enough facilities are being created to cater for future needs. In the past, South Africa has seen very little real growth in fixed investment due largely to factors such as the high crime rate and labour unrest which have discouraged investment.

National income - Just as total expenditure in the economy is important, so too is total income, since this determines what is available to be spent. The total income of individuals, households and businesses is called the national income. In practice, national income is derived from the other basic quantities such as GDP. There is a relationship between these two:

One can either look at the economy from the spending point of view, or equivalently;

The income earned in the form of salaries, wages, rents etc. to produce the output of the economy.

National income is also divided into various categories of which:

Disposable income is one of the most important. Disposable income is the amount of money available to households, individuals, business and government after tax has been deducted.

Personal disposable income refers to the disposable income of individuals and households. This is the money actually available to people from their salaries and other sources of income, which they can choose to either spend or save.

Disposable income in turn is divided into:

Private consumption expenditure;

Government expenditure, and

Savings.

This illustrates the way the national economy forms a circular flow with income flowing into spending (and saving) which in turn form the "factor payments" which relate back to GDP.

Savings are an important part of income allocation. There is considerable concern about the low rate of personal savings in South Africa (the ratio of personal savings to personal disposable income). If less money is saved, it means that less money is available for investment (since money not saved is spent on consumption activities). Inadequate investment is negative for the economy.

The Balance of Payments (BoP)

The South African economy is an open economy, which means relying to a large extent on trade with foreign countries. Just think of the substantial exports of gold and minerals and the need to import complex pieces of equipment. This makes the balance of payments very important. A country makes many types of payments to other countries. Amongst other it pays for:

Imports;

International assistance schemes;

Royalties;

Insurance;

Services;

It pays interest and dividends;

It repays loans;

It makes payments after disinvestment by foreigners; and

It also pays for investment by South Africans nationals in other countries.

Similarly, it receives payments for many things.

If there is a shortfall of receipts against payments this shortfall is met from the gold and foreign exchange reserves. If the reserves are insufficient to meet the shortfall, then the country must borrow, or sell an asset overseas, in order to increase its receipts. A country's reserves can be likened to an individual's bank account. If he spends more than he receives then his balance will go down and vice versa. Money is a commodity, which can be in short supply, in which case interest rates (the price of money) will go up and vice versa.

The level of reserves affects the level of economic activity (i.e. whether we are in a growth or recession phase) in the country. When the reserves are high, the country is liquid (has a loose-money position) and interest rates come down and economic growth is stimulated. Against this, when reserves are low, interest rates increase, liquidity (the amount of money in the economy) becomes tight, and economic growth slows and may even become negative. When interest rates increase, this immediately puts pressure on the level of economic activity in various ways. For example, increases in the bond rate (i.e. home loans) reduce the amount of disposable income that people have, so that they tend to spend less, especially where there are several increases in the rate.

Similarly, when interest rates rise, companies that have substantial overdraft facilities or other debts will immediately feel the pinch as their interest bill increases. They will also begin to cut back, retrenching staff and postponing the decision to buy more heavy equipment, further reducing demand. The point is that changes in interest rates have a far-reaching effect on the economy, and hence the share market. The level of reserves is one factor affecting interest rates, because when the reserves are awash with cash, interest rates are inclined to fall.

Factors affecting the reserves

There are two elements of the Balance of Payments which affect the level of reserves in South Africa:

The current account - The current account shows the trade with the rest of the world. This shows the "gap" between exports less imports. Note that this does not only consist of the import and export of tangible goods but also so-called "invisibles". These include payments for services such as shipping and insurance, royalties paid to overseas principals, etc.

In South Africa, gold is considered a merchandise export; although in most other countries in the world, which do not produce as much gold, it is regarded as a monetary payment. (In Switzerland, for example, a law was approved for the abolition of a requirement that the Swiss franc to be backed by gold reserves). Because gold is included in the merchandise exports of South Africa, a change in gold price is soon reflected in the trade balance and hence in the reserves. South Africa's B.O.P. is gradually becoming less and less dependent on gold as manufacturing and non-mining exports increase and gold output declines.

The capital account - Secondly, we have capital account flows, which reflect the long- and short-term capital in an out of the country. Long-term capital flows amount to either long-term loans or direct fixed investment, either into South Africa from outside, in which case there is a capital inflow, or by South Africans to countries outside South Africa, in which case there is capital outflow. It can also happen that foreigners dis-invest from South Africa, in which case there is an outflow of a longer-term nature.

The impact of balance of payments (BoP) on the economy

The balance of payments has a substantial effect on the economy, particularly if, in South Africa's case, it is an open economy. In the apartheid years, we saw that the decision by foreign banks to call in their loans to South Africa resulted in large annual outflows of capital. During the late nineties, with the Asian financial crisis, we saw how capital outflows caused havoc with the emerging markets.

In the past, the fact that there had been substantial outflows of capital meant that a surplus had to be maintained on the current account to protect the reserves. The need to maintain a current account surplus had, in turn, resulted in the authorities having to curb economic growth. This was because as the economy starts taking off, imports rise which leads to a deficit on the trade account putting pressure on the current account.

The other important way in which the BoP influences the economy is through reserves. A country has to maintain a reasonable level of gold and foreign exchange reserves to pay for its imports (the minimum requirement is generally 3 month's imports). If the level of reserves drops below this, the authorities will take action to protect the reserves. This could take various forms such as raising interest rates in order to attract foreign capital. But this action will also choke off imports by reducing economic growth.

The combination of the flow of capital, the services account balance, and the trade account balance makes up the balance of payments, which, in turn, affects the level of reserves. As the name suggests the BoP must "balance". If, for example, there is a net outflow in the current account and capital account combined, then this is reflected in the BoP by a draw- down on the country's reserves of gold and foreign exchange. The reason, incidentally, why a country must hold foreign exchange reserves is to pay for its imports. An American supplier of computer equipment to South Africa, for example, cannot be paid in Rands - he needs Dollars.

The exchange rate

The exchange rate of a country's currency reflects what other countries are prepared to pay for its currency. In very much the same way as a share reflects investors' perceptions of a company's future prospects; so does a currency reflect the perceived prospects of a country? Thus if the exchange rate of the Rand against the American Dollar is R 10.00, it means that South Africans have to pay R 10.00 to purchase one US Dollar in the foreign exchange market. Conversely, one Rand buys 10 US cents.

The exchange rate is determined in an open market by supply and demand. A system called a floating exchange rate is used in South Africa. Although the exchange rate is basically determined by supply and demand, the Reserve Bank can intervene (although this practice is being curtailed) to smooth out excessive fluctuations. If the exchange rate falls sharply, for example, the Reserve Bank can sell Dollars for Rands in the foreign exchange market thus pushing down the exchange rate of the Dollar against the Rand. Note that the foreign exchange market has no physical location. It consists of all the currency transactions conducted by the Reserve Bank, commercial banks, speculators, etc.

The exchange rate depends on many factors. One of these is the inflation rate in a country versus the inflation rate of its trading partners. South Africa's inflation rate, for example, has been considerably higher than that of countries such as the UK, Germany and America. This means that South African product prices are continually rising faster than those of its trading partners, thus pricing themselves out of the international market. However, if the exchange rate is allowed to compensate for this then the prices remain more stable. This is called purchase power parity.

Purchase power parity can be explained as follows: Assume the inflation rate locally is 15% but in the UK only 6%. Furthermore assume a manufacturer of shoes sells these for R 116 a pair locally. If the exchange rate is R 13.00 to the British pound, the item will sell in the UK for 116/13.00 = £ 8.92 (ignoring transport costs).

Assume a British manufacturer sells his shoes for the same price. After a year, the local price has increased from R 116 to R 133.40 (15% increase) due to inflation. Assuming the exchange rate is unchanged, this converts to £10.26. But the British manufacturer's price has only increased by 6% to £9.46. This will make the South African produced pair of shoes too expensive. If, however, the exchange rate falls from R 13.00 to R 13.50 to the Pound, the UK price would be 133.40 / 13.00 = £ 9.88 which is much closer to the British manufacturer's price.

The exchange rate falls; the shoes are now £ 9.88, which is much closer to the British manufacturer's price.

The price is increased to £ 9.46

The Reserve Bank may intentionally allow the Rand to weaken because this would be good for South African exports. Another factor, which can influence the exchange rate, is the level of reserves since, if a country's reserves are under strain, other countries will not have much confidence in its currency and its exchange rate.

The exchange rate and the balance of payments

It is important to understand this relationship, especially the trade account. When the rand falls in value relative to the currencies of our major trading partners, then our exports become cheaper overseas, while imports of foreign goods becomes more expensive locally.

At one time the Rand was worth $ 1.36, it then subsequently fell to being worth about $0.13 cents. The result of this rapid decline has been that South Africa achieved a trade surplus of over R 1bn per month for more than five years! This huge trade account surplus was used to meet substantial outflows on the capital account as overseas debt was repaid, and as investors withdrew money from the account.

Before

After

One Rand was worth $1.36

One Rand was worth $0.13 cents.

E.g. Owed $30-billion or R 22-billion

E.g. Owed $30-billion or R 230-billion

If the Rand depreciated; our debt would have increased proportionately.

Because the Rand depreciated; the debt increased proportionately.

From an investment point of view an important factor is the link to interest rates. The exchange rate is strong when there is an inflow of foreign capital into South Africa and weak when there is an outflow. One of the reasons for an inflow of such foreign capital is due to the higher South African interest rates relative to foreign interest rates. It therefore pays foreigners to invest in South African money market products. When our exchange rate is strong we can therefore expect lower interest rates. Likewise a weakening currency will result in higher interest rates. This was clear during 1998 when foreigners removed large funds out of the country.

Managing the economy and interest rates

The role of the Reserve Bank

The Reserve Bank's main function is monetary policy. Policy decisions are made with the objective of achieving low and stable inflation over the medium term. Other major roles are maintaining financial system stability and promoting the safety and efficiency of the payments system. The Bank is an active participant in financial markets, manages the country's foreign reserves and issues currency notes. The information provided by the Reserve Bank includes statistics - for example, on interest rates, exchange rates and money and credit growth - and a range of publications on its operations and research. More on the functions of the Reserve Bank will be discussed under Monetary Policy

Interest rate cycles

One of the most reliable indicators for investors is interest rates. Interest rates are merely the price of money. Like all prices, interest rates are determined by the interaction of supply and demand. The greater the demand for anything, the higher the price and vice versa.

The larger the supply of money and the weaker the demand; the lower the interest rates will be.

When money is in short supply and demand is high; interest rates will rise.

As the demand for money increases, interest rates should also increase. Interest rates react to the economic cycle, rising during boom periods when money is in demand for business expansion etc. and falling during slump conditions. High interest rates are negative for profits, and because the market will generally anticipate this, it will peak well in advance of interest rates. As a result, the two cycles are not synchronised. The direction of interest rates could give you a valuable lead to future stock market movements.

Generally speaking, when interest rates rise, money that otherwise would have found its way to the JSE is likely to be directed toward interest-bearing investments. The move away from the stock market has the effect of lower share prices. Furthermore, as valuations are done using a discount rate linked to interest rates, higher interest rates will cause lower stock market valuations. A third impact of higher interest rates is companies pay higher interest and consumers pay higher interest (consumers will have less money to spend on companies' products), therefore profits decline. Lower company profits mean lower share prices.

Important: Higher interest rates are negative for the stock market and lower interest rates are positive for the stock market.

The monetary authorities can influence the economy by influencing interest rates. For example, if they believe that a boom is getting out of hand, they allow interest rates to rise and keep them as high as is necessary to put a lid on the economy. Anyone with a home loan will realise how painful such sustained high interest rates can be!

There is a multitude of different interest rates in the economy. The basic distinction is between short and long term interest rates. For instance, the interest rate paid on a cheque or savings account is an example of short-term rates. They apply to money which is "on call" or available immediately. Interest earned on a fixed deposit of three years is an example of a long-term interest rate. Usually long-term interest rates are higher than short-term interest rates because money is tied up for longer and therefore the lender wants a better return for not being able to put his money to other uses.

Important interest rates

Bankers Acceptance (BA) rate - A banker's acceptance is a type of Bill of Exchange, which was originally used, in international trade. By sea, cargo sent overseas takes a long time to get there. To take account of this delay in the date of shipment and the date of delivery and payment, bankers acceptances were devised. A banker's acceptance, like a cheque, can be used as a type of money. Whoever "owns" it, in fact owns an asset (payable in cash at the expiry of the bill) and can use it in the settlement of transactions. BA's are issued for periods of one, two or three months. The 3-month banker's acceptance (BA) rate was an important short-term interest rate in the money market and was widely used as an indicator of interest rates. This was subsequently changed to the Bank rate or "repo rate" as the indicator of future interest rate trends.

The Repo rate - The central bank of a country is the "lender of last resort" to the banks. So the repo rate is the rate at which the Reserve Bank lends to commercial banks. Thus if banks need money urgently (e.g. to tide them over a shortage at month ends) they go to the Reserve Bank. The Reserve Bank regularly advances money to the banking sector by issuing treasury bills (TB's) which are used to finance government spending. These are similar to BA's in that they run for a certain period of time (usually 3 months) and are issued at a certain discount rate. However, when an institution offers TB's to the Reserve Bank for re-discounting, the rate at which this is done is called the bank rate or Repo rate.

By controlling the amount of TB's on offer at its weekly auctions, the government can, in fact influence the Repo rate and thus also other rates in the money market. To understand how this works, let us suppose that the government increases the rate at which it re-discounts TB's. This would mean that the banks have to raise their rates (since they have to pay more to have them re-discounted by the Reserve Bank). Thus short-term interest rates should rise. Treasury bills are used to drain liquidity from the banking system. The authorities may decide that there is too much money available, and therefore reduce the money supply, which is a means for the authorities to manage the economy.

The prime overdraft rate - This is the rate of interest charged by banks on overdrafts applicable only to its best customers, such as large companies. Although the prime rate is the rate generally quoted as indicative of interest rates in overdrafts, in practice banks charge a much wider range of rates on overdrafts. Other customers may pay the prime rate plus one or two percentage points more. This rate, like other short-term rates, depends on the repo rate. If the repo rate rises, so too will the prime rate.

Real interest rates

For purposes of ensuring low inflation, not only the quoted or nominal level of interest rates should be taken into consideration, but also real interest rates. A real interest rate is calculated (in the simplest way) by deducting the inflation rate from the nominal interest rate. To use a simple example: if the interest rate on a mortgage bond is 15% per annum, and the annual inflation rate is 8%, the real interest rate is 7%. International comparisons of interest rates should be done on the basis of real rates, not nominal rates.

The money market

This is the market in which bankers acceptances, treasury bills and other short-term financial instruments are discounted and traded. It has no physical floor but operates through the activities of institutions such as banks and the Reserve Bank. One of the major reasons for the existence of the money market is to allow financial institutions such as banks to either:

Borrow money for short periods, or

To "park" money (often overnight) when they have excess funds available.

Inflation rate

Inflation is the phenomenon of prices increasing from year to year or alternatively, the decline in the purchasing power of paper currencies. In the long term, inflation is caused by governments increasing the money supply faster than the growth of GDP. Put another way, money is simply a symbol of these goods and services produced by and owned by the whole economy. If the size of the money supply increases by 20% while the number and value of goods and services remain the same – then there will be 20% more money chasing the same goods and services. Sooner or later the prices will rise.

Inflation is measured by measuring prices. A very common measure is the Consumer Price Index (CPI), which measures retail prices and expresses the result as an index figure. Inflation is then the annual percentage increase in the index. From 1974 to 1992 the South African inflation rate has ranged between 10 and 20 per cent. It has been brought down to less than 10 per cent per annum since 1993.

From an investment point of view, inflation is most important as an indication of where interest rates are heading. When inflation is on the rise, interest rates will follow as the monetary authorities use higher interest rates as a tool to fight inflation. Likewise when inflation decreases interest rates should also decrease.

The different classes of inflation measurement are as follows:

Headline Consumer price inflation (CPI) this is more commonly used as the inflation index. It is a basket of goods commonly purchased by households – the price of this basket of goods is monitored on a regular basis. Certain weightings are given to the more important items, such as petrol and bread, and from this we can determine the rate and level of price increases in general. Inflation is the rate of change in the CPI (or other index) over a period of time.

CPI(X) is the headline consumer price inflation excluding mortgage bond rates. This is the measure that the South African Reserve Bank (SARB) currently uses for inflation targeting purposes (between 3% and 6%).

Producer price inflation (PPI) is a comprehensive index of wholesale price changes, often viewed as an indicator of future retail price changes.

The importance of low inflation

The central aim of all the Reserve Bank's policy actions is low inflation. Low inflation means that money will lose value only slowly, if at all, over a period of time. Money serves three functions, namely:

Money serves the purpose of being a means of payment.

It is a unit of account used in measuring the value of goods and services.

It also serves as a store of value for the savings of the community.

These three functions of money make it essential that the value of money should remain as stable as possible. No modern market economy can function well if its currency continuously loses value.

Inflation is a continuous decline in the value of money. This will be reflected in the ever-increasing prices of all goods and services. It is important that price inflation should be contained at its lowest possible level for the people of a country to have faith and confidence in the value of the money they use.

Low or zero inflation does not imply that the prices of goods and services will not change at all. Prices in a market economy will always change in response to changes in relative scarcities. A change in relative scarcity means that something becomes either less or more available than before. To use an example: a fire in a factory of Billabong might result in a smaller supply of Billabong clothing and, therefore, a higher price for Billabong clothes in comparison to Quicksilver clothing. However, this is a change in the relative scarcity of Billabong products and not the result of general price increases.

Low inflation means that the continuous rise in the general price level, i.e. in the prices of all goods and services, drops to such a low level that it no longer influences the decisions of consumers and producers.

A precondition for the efficient working of a market economy is that producers and consumers must be able to identify changes in the relative prices of goods and services. The identification of changes in relative prices allows producers and consumers to take appropriate economic decisions which ensure the most efficient allocation of productive resources, especially in respect of the use of labour and machinery and the purchase of goods and services. A serious problem occurs when all prices rise continuously.

Producers and consumers can then take wrong decisions because they cannot distinguish properly between the changes in relative prices (reflecting relative scarcity) and price increases that form part of an ongoing inflationary process. Economic efficiency is sacrificed and scarce resources may not necessarily be used efficiently during periods of continuous high inflation. High rates of inflation inevitably lead to a decline in the efficient working of a market economy and in the medium to longer term, to a lower rate of growth of the economy as a whole and, therefore, also to less employment creation.

Although it is sometimes stated publicly that higher inflation will create jobs, this is not true. Higher inflation destroys jobs in the long run. It is true, however, that policies aimed at lowering inflation might have a short-term negative effect on job creation.

Apart from disguising changes in relative scarcity, other important disadvantages of inflation are:

Losses to savers, because the capital value of their savings loses value as the value of money becomes eroded by rising prices.

Losses to people with incomes fixed in money terms, e.g. pensioners.

Increased efforts to hedge against price rises by investing in assets such as precious metals or collectables, instead of focusing on production.

Resources are wasted under conditions of hyperinflation, e.g. 10 000 per cent per annum (which South Africa has, fortunately, never experienced), as prices have to be revised frequently, which is a costly procedure.

The Reserve Bank's approach is to lend money to banks at such an interest rate that enables inflation to be brought and kept under control. The Reserve Bank's aim is not to keep interest rates unduly high, but to keep them at a level sufficient to achieve the inflation target of 3% to 6%.

The tools for managing the economy

We have looked at the economic background and some of the issues that are important. We saw that the need may arise for the government or monetary authorities to intervene in the natural course of economic events.

Now we will look at how governments intervene in the economy to try and achieve certain desired goals such as growth and employment. For example, in a situation where the economic boom gets out of hand, driving up prices to unacceptably high levels and perhaps putting a strain on the balance of payments, the government may step in to "cool" down the economy. The need to manage the economy thus arises either from constraints imposed on the economy (such as a balance of payments constraint) or the desire to improve performance.

The two major instruments available for this are:

Monetary policy; and

Fiscal policy.

Monetary policy

Open-market operations entail the buying and selling of government securities by the Reserve Bank in the open market at the Bank's discretion in order to influence conditions in the money market or the level and pattern of interest rates. The transactions concerned are termed operations in the open market because the Bank is prepared to deal with any interested party. Although these transactions are primarily undertaken to achieve long-term monetary objectives, a secondary objective may be to iron out temporary money market fluctuations caused, for example, by tax payments to the Exchequer, other changes in the Government's balances with the Reserve Bank, or changes in the Bank's net gold and other foreign reserves. If these operations are conducted with the private non-bank sector, they will influence the money supply directly (if deposits at banks are used to pay for the operation), but also indirectly by affecting the cash reserves of banks as well as the need for Reserve Bank accommodation, which, in turn, may influence interest rates. Similar money-market effects may be obtained from the Reserve Bank's sales of securities to banks.

Through the daily refinancing of the banks' liquidity requirement, the Reserve Bank can indirectly influence the cost at which money is made available to commercial banks. The daily refinancing of the bank occurs by way of a daily tender, where the banks will sell financial assets in exchange for cash from the Reserve Bank, but they will bid (tender) for this cash. This system, introduced in March 1998, is called the repo system where banks have to buy back (repurchase) the assets they sold to the Reserve Bank. The Repo is conducted when the banks have a need for cash, but at times there may be a surplus of funds in the market and then the Reserve Bank will conduct a reverse Repo. The average rate at which all the banks tender for the cash that the Reserve Bank provides, is called the repo rate. This rate has replaced Bank rate which was a rigid rate set by the Reserve Bank. By contrast, the repo rate is variable, far more flexible and is determined by the market (i.e. the banks).

The Reserve Bank estimates the banks' need for liquidity and by varying the amount of liquidity it makes available at the daily tender, it signals monetary policy and thus indirectly influences the Repo rate. The Repo rate affects the level of short-term market rates. For example, if the Repo rate is high, the banks raise the interest rates at which they lend money to their customers. This causes a rise interest rates and eventually helps to control inflation by stemming the public's demand for credit and disciplining the amount of money in the economy. The Reserve Bank plays a very important role in determining the state of the South African business cycle. While they cannot cause the cycle, the Reserve Bank certainly can reduce the impact of a downturn or severely lessen an upturn. They do this by the use of monetary policy.

Monetary policy involves the deliberate manipulation of interest rates by the Reserve Bank in order to achieve certain policy goals. The Bank's primary objective is monetary stability and balanced economic growth. We have seen that the Reserve Bank does this mainly through the manipulation of the rediscount rate of Treasury Bonds (TB's), the so-called Repo rate. The rise in the repo rate quickly affects all other interest rates and thus has a knock-on effect throughout the economy. It was once thought that inflation was an inescapable consequence of economic growth. As more money was pumped into an economy, so the theory went, prices would rise. Since then, economists realise that it is possible to have growth without inflation. Inflation will only rise where money is created without an equal increase in the production of goods and services. Central banks the world over are now pursuing "sustainable economic growth" by keeping interest rates at relatively restrictive levels i.e. making it more expensive to borrow and being careful to artificially stimulate the economy through cheap money. It has generally been established that the central bank of a country should concentrate on monetary stability, which encompasses the control of inflation and maintaining the currency at a reasonably stable level against the currencies of major trading partners.

Inflation damages the economy in a variety of ways by eroding some of a currency's most important functions, i.e. as a store of value. Inflation also hits the poor the hardest, e.g. someone earning R 300 a month is less able to sustain price increases of say 10% a year than someone earning R 6000 a month. Inflation therefore widens the gap between the rich and the poor and is socially divisive for any country with already wide income disparities. It is therefore important to understand that low and stable inflation is a prerequisite for achieving sustained growth.

Over the long term, it is true that inflation results from increasing the money supply more quickly than the economy is growing in real terms. However, in the short term the "velocity of circulation" can reduce or increase the level of inflation. The velocity of circulation is literally the speed with which money moves in the economy.

If the level of economic activity is high, then money is moving quickly and inflationary pressure will increase.

If the level of economic activity is low, then money is moving slowly and inflationary pressure will decrease.

There are also other important goals of monetary policy such as controlling money supply. This is also mainly accomplished through the sale and purchase of short- and long-term government stock, in the so-called open market operations of the Reserve Bank and through changes in interest rates. By using interest rates as a prime tool of monetary policy, the authorities can lower the rate of economic growth, while the economy is in a boom, by allowing interest rates to rise and to stay high for as long as it is necessary to reduce economic activity. This will encourage people to start spending less and to begin saving. On the other hand, if the economy is in a recession, interest rates may be kept low in order to stimulate spending and investment.

There is no guarantee that either policy- of high or low interest rates will do the trick, particularly not in the short term. Low interest rates, for example, will not necessarily lead to higher investments since there are other factors at work, such as the level of confidence, which effect decisions about investing. Similarly, in a boom period, if interest rates are kept high, people and businesses may not curtail their expenditure. For various reasons they may continue to spend at a high rate despite the high interest rates. Critics of monetary policy often point to the massive harm that is done to the economy by keeping interest rates high for a long time in terms of business closures and job cuts.

Fiscal policy

This is just another name for the government's tax policy. It refers to the conscious use by the government of its own spending power and ability to impose taxes to influence economic growth.

The budget is the main document through which the government implements its fiscal policy. By consciously allocating more of its income to projects such as road building or education, the government helps to provide work to contractors and others supplying goods and services it requires. This in turn stimulates further economic activity as wage earners employed by the contracting firms spend their money.

An important aspect of monetary and fiscal policy is that they should be coordinated. It is futile that the Reserve Bank raises interest rates to dampen economic activity if the government continues to spend at a high level. Although this sounds obvious, in practice it is harder to accomplish e.g. when the government is under considerable pressure to increase its spending on social up-liftment (housing, schooling, etc.) while at the same time pursuing a strict monetary policy to control inflation.

The budget

Although on the face of it the budget is merely an accounting exercise in trying to match anticipated income with planned expenditure, its significance is actually far greater. It is in fact the most important document of fiscal policy and signals the so-called "fiscal stance" of the government to the private sector. For example, is the government adopting an expansionary approach to the economy or not and what is its spending priorities in the future likely to be? This allows businesses particularly to plan ahead with greater certainty. Before the British economist Keynes introduced the subject, the idea of "budget deficit financing" was a loathing to governments. The idea was that just like a prudent household that tries to live within its means, so too should the government balance its books without access to borrowing or printing money.

After Keynes the idea of deficit financing became acceptable (because his views about the government having to step in and spend money when the private sector was not doing so). Unfortunately some countries have become so "addicted" to deficit financing that it has assumed almost unmanageable proportions (e.g. the American budget deficit has become a real problem which successive administrations seem unable to contain).

When a country runs larger budget deficits year after year, the size of the national debt grows (since the government must borrow the money to finance its deficit). Eventually the interest on the government debt becomes a major drain on the government's finances.

The investment cycle

Like most things in life the stock market works in cycles. Share prices do not always go up and neither do they always go down. Furthermore it is biased in the investor's favour as the long-term trend is up. As long as a country's GDP grows (we are talking long term here, never mind the frequent quarters of negative growth that is normal in the economic cycle), the businesses fuelling this growth will become worth more. A well-diversified portfolio is bound to return positive results, without Einstein being involved in its selection at all. So although you know that you should do well over the long term this does not help when your portfolio drops by 50% in the short term. Maybe it will help to understand a bit more about the investment cycle.

The normal economic cycle is loosely based on a boom-bust situation. For this explanation we will work with four phases in a cycle, starting with phase II. The reason for starting with the second phase will eventually be clear.

Phase II starts with low interest rates, inflation is under control and the economy is growing at a steady (average) rate. Due to the low interest rates spending increases, the economy grows faster (above average), but unfortunately this leads to higher inflation. The fear of inflation forces the central bank to influence increasing interest rates. The object is that more expensive money will lead to a decrease in spending and therefore inflation will once again be under control.

During phase III interest rates increase further (there is a lag between increased interest rates and subsequent lower inflation) as the central bank remains worried that the strategy is not working. The higher interest rate eventually have a negative effect on spending and therefore the growing economy starts to show the first signs of slowing down (moving towards average GDP growth).

In phase IV inflation is once again under control but the slowing economy begins to worry the central bank and interest rates start to trend slowly downward with the object of increasing spending in the economy. This normally arrives a little bit too late and economic growth slows down to almost a standstill, it might even occasionally slip into a depression or a recession. By this stage interest rates are falling at a faster rate in an effort to avoid a depression/recession.

Phase I starts with the economy levelling off and slowly starting to grow at a faster rate (albeit still below average). At the end of this phase the central bank is happy with economic growth, slaps themselves on the shoulder for their excellent reading of the situation and put a halt to decreasing interest rates. Return to phase II above for the next phase.

This is more or less how the economic cycles runs, the phases are not always of equal length and certain parts might lap over to another phase. External problems like an economic crisis in Asia will also have an effect and under such circumstances the business cycle theory might even seem redundant. But over the long run this is more or less how an average cycle will work. The peaks or troughs might be lower but the general direction will remain intact.

But how does the business cycle influence the investment cycle? Most uninformed investors will take the logical route where the economy is steaming ahead. So start in the middle of Phase I when the economic growth picks up and remain invested throughout Phase II. Then in Phase III when economic growth starts slowing down get out. Remain out the market until the economy recovers again in phase I. This is also the way a lot of investors actually invest. When the economy is growing, it feels good and everybody is optimistic, then you buy. When growth slows down, optimism is replaced by pessimism and you sell. Try this technique and you really will have reason for pessimism.

The stock market is a leading indicator of the economy and it tends to foreshadow a downturn 9 to 18 months in advance of a peak in economic activity. About 4 to 6 months prior to the trough of a recession, the stock market begins a very strong recovery, which generally accelerates through the trough of the business cycle. When the economy is growing, think of selling and when the economy is doing badly think of buying. This "unnatural" way of the stock market is illustrated in the following graph. Please do not think that the real graph looks as synchronised as this one, it is purely for illustrative purposes.

At the beginning of phase I the economy is still performing below average and "rational" investors remain wary of the market. As the economy starts picking up towards the second half of phase I these investors believe it is time to be invested, but unfortunately this is where the stock market's above average performance are coming to an end. Initially it still advances which only temporarily vindicates their clever decision. Unfortunately it then started its downward path and when they sell out by the end of Phase III (with the economy moving into below average growth and they have lost all belief in the stock market), the stock market is nearing its low. Long before the economy turns (and they are still out of the market), the market reverses its trend and the good times are back. Unfortunately these "rational" investors are missing out on these good times and remain out of the market because of the still depressing economic news. Slightly before the stock market peaks, the economic news become more positive and back in they jump. Oops!

It is important to read the above graph correctly. When the graph is below the line it does not mean that the economy or stock market is necessarily slowing or in negative growth it simply means that growth is below average. The economy grows at above average rates during phases II & III, while the stock market grows at above average rates only during Phase IV & I.

In tabular form this would look as follows:

Phase I

Phase II

Phase III

Phase IV

Economic growth

Below average

Above average

Above average

Below average

Interest rates

Decreasing

Increasing

Increasing

Decreasing

Stock market

Above average

Below average

Below average

Above average

It seems that the stock market does the opposite of economic growth and interest rates.

The following table on the US stock market ratifies this.

Phases of the US growth cycle and asset returns first quarter 1970 to second quarter 1995 returns on different asset classes.

With the exception of commodities (which move more in line with economic growth) the other asset classes all outperform during Phase IV & I of the cycle. Interesting that bonds also outperform in the same time of the cycle as does equities, although equities still perform better than bonds in those phases. We therefore question the conventional wisdom of moving somewhere during the cycle away from equities into bonds. As the return on cash shows it would be wiser at such times to rather move directly into cash. From the return on cash we can also see what interest rates were doing in the different cycles. This return would be an average over the phase. The average during phase I was 5.6% moving to 6.5% in phase II. Phase II therefore showed increasing interest rates.

The same in Phase III where the return increases to 8.25%. Although Phase IV at 8.1% remains high, it is lower than in Phase III, therefore a phase of decreasing interest rates. These rates further decrease to an average of only 5,6% in Phase I. The interest rate cycle is also depicted in our graph. Keep this in mind as we will be returning to interest rates as stock market indicators.

So all you have to do to make money in the stock market is wait for the economy to perform below average, invest and then divest as soon as the economy recovers to above average growth. Sounds easy. Unfortunately the problem with the theory is when will you know how the economy is performing? These figures are normally released months after the fact, by then it will already be too late for action. So although this above seems plausible in theory, in practice you will end up chewing off your wrists in frustration.

Did we therefore waste your time with the business cycle? Definitely not. A more practical indicator to use is interest rates. The long-term government bond yields, the repo rate and prime rate is available on a day-to-day basis. This information can be used with much more reliance. Furthermore unlike GDP growth there is no chance of a revised figure 12 months after the fact. Today's interest rate is a given.

Why is that? It is because one of the most important drivers of share prices are interest rates and not the economy. When interest rates decrease, the stock market increases, and vice versa. Look again at the above graph, but this time ignore the economy and rather focus on interest rates. Interest rates start decreasing slowly in Phase IV, after the market has already started its recovery. Hold onto your investment throughout Phase IV and sell at the end of Phase I when interest rates are heading upwards once again. You would have enjoyed the bulk of the increase in share prices. The following is an example of how a system based on buying when interest decrease and selling when interest rates increase worked in the US market.

Prime rate indicator vs. Standard & poor's 500 index: 1954 to 1996

Buy signals

Sell signals

Date

S&P

Change

Date

S&P

Change

3/17/54

26.62

54.8%

10/14/55

41.22

0%

1/22/58

41.2

41.1%

5/18/59

58.15

-1%

8/23/60

57.75

54.0%

3/10/66

88.96

-4%

1/26/67

85.81

11.7%

4/19/68

95.85

7%

9/25/68

102.36

5.6%

12/2/68

108.12

-24%

9/21/70

81.91

21.8%

7/6/71

99.76

-4%

10/20/71

95.65

12.4%

6/26/72

107.48

-11%

1/29/74

96.01

1.3%

3/22/74

97.27

-24%

10/21/74

73.5

20.7%

7/28/75

88.69

1%

11/5/75

89.15

10.6%

6/7/76

98.63

5%

8/2/76

103.19

-6.9%

5/31/77

96.12

12%

12/7/79

107.52

6.6%

2/19/80

114.60

-8%

5/1/80

105.46

18.4%

8/26/80

124.84

9%

12/22/80

135.78

-0.5%

4/24/81

135.14

-2%

6/16/81

132.15

-0.2%

6/22/81

131.95

-11%

9/21/81

117.24

0.5%

2/1/82

117.78

-9%

3/8/82

107.34

1.8%

3/16/82

109.28

1%

7/26/82

110.36

46.4%

8/10/83

161.54

3%

10/15/84

165.77

73.8%

5/1/87

288.08

-12%

11/5/87

254.48

-0.5%

5/11/88

253.31

31%

7/14/89

331.84

33.4%

4/19/94

442.54

37%

12/20/95

605.94

7.3%*

*Through 3/20/96

Signals $ 10,000 becomes: $318,068

With sell signals $ 10,000 becomes: $ 7,676

Annualised return = +15.5%

Annualised return = -1.5%

Buy-and-hold return = +7.9 % per year

Percentage of signals correct: 81,8%

Percentage of signals correct: 57,1%

Source: Martin Zweig's Winning on Wall Street

Interest rates are also a more practical indicator to use as it is public information as and when it happens. GDP growth figures are only released months after the fact, by then the stock market has already reacted. Furthermore the central bank uses interest rates to either slow the economy down or help the economy into a growth phase. Interest rates are therefore a tool used to steer the economy (and inflation) and not the other way around. So forget about the economy and rather focus on the direction of interest rates. The stock market and economy will follow.

The easiest way to see in which part of the interest rate cycle we are is to keep an eye on the Repo rate as well as the long bond rate (R186), both these rates can be found in your daily newspaper. The Repo rate is set by the Reserve Bank on a daily basis, when this rate declines day after day you can be sure the major banks will follow with a drop in their prime rate. Likewise the R186 is a good indicator of the general direction of interest rates. Although this rate is more volatile than the repo it is worth keeping a keen eye on. What else should we look at to give an early warning about a change in the direction of interest rates?

An earlier mention was made about inflation targeting. This is the policy that the South African Reserve Bank (SARB) is using. The inflation term used is called CPI or Consumer Price Index. This is South Africa's measure of consumer inflation. The target is an inflation rate of between 3-6%. What this means is that when inflation is higher than these levels, interest rates will also be kept at higher levels. Higher interest rates eventually lead to lower inflation. Where inflation is well inside these parameters, there is an excellent chance of stable or lower interest rates. So keep an eye on inflation, high inflation means higher interest rates and a lower stock market. Low inflation is good news for interest rates and therefore the market.

One should furthermore remember that the SA economy does no longer function in a vacuum. Our economy is part of the global economy and will therefore be affected by what happens in the global arena. The level of the exchange rate is an important factor for local interest rates. Our country needs foreign capital to survive. When there is a large inflow of foreign capital into our markets the result is a stronger currency. This also means that our interest rates are high enough to compensate these foreign investors.

A strong currency is positive for interest rates. The exchange rate will become weaker when foreign investors remove their funds from our country. One method of getting these funds back is to raise interest rates to make it more profitable for these investors to bring their money back into the country. A weakening exchange rate is negative for interest rates and therefore the local stock market. In tandem with the exchange rate are our interest rates relative to those of our large international trading partners like the US. When interest rates decline for example in the US, our interest rates become more attractive from a relative point of view. Likewise when the US increases their interest rates it is going to be very difficult for SA to have lower interest rates. Foreign investors would then rather invest in the US money market, which will lead to an outflow of capital in SA, and eventually higher interest rates.

Although the above seems rather complex for a private investor in summary it would look something like the following:

Stock market

Above average performance

Under average performance

Interest Rates

Declining

Increasing

Inflation

Declining

Increasing

Economy

Below average

Above average

Exchange rates

Strengthening

Weakening

Foreign Interest Rates

Declining

Increasing

So for those investors that are not interested in the day-to-day fluctuations of the stock market but rather in the long term buy or sell signals of the market overall, interest rates must be one of the most important economic indicators to follow. Remember like all other indicators interest rates are not infallible and therefore should rather be seen as a further (but very powerful) weapon in the investor's arsenal.

Conclusion

In this tutorial, we looked at macroeconomics, which is the study of national and international economies but also discussed the various terms in use, such as Balance of Payments (BoP), Inflation, Interest Rates and many more.

Economic analysis is a "top-down" approach to share analysis as it teaches us that if we know what is happening in the economy at large, we can then determine trends on an industry-wide basis and then, more specifically, on a company-wide basis. Economics is the study of human behaviour and the use of money as a medium of exchange with regard to the supply and demand of goods and services.

The "bottom-up" approach to share analysis looks at the prospects for the economy by first looking at the individual companies, then the industry and then the economy at large. Micro economics looks at the parts which make up the national economy and studies the supply and demand of individual products.

In the next tutorial, we will be discussing micro fundamental analysis, where the aim is for you to see if you are putting your money in a good or bad company and whether it is worth your while to invest in the company.

Support

If you have any further queries, please feel free to contact our educational team on shaunvdb@psg.co.za or call 0860 PSG PSG (774 774).